ChartIQ Guides

Relative Strength Guide

ChartIQ’s RSI Divergence and Positive/Negative Reversal Study

ChartIQ Plus includes RSI Divergence, which automatically calculates and plots price targets based on bearish/bullish divergences and Momentum Discrepancy Reversal Points (aka positive and negative reversals). This expands on ChartIQ’s Relative Strength Index (RSI) and Composite RSI features, giving you powerful tools to identify likely reversal in market trends. These features are based on the research and writings of J. Wells Wilder, John Hayden, Constance Brown, and Andrew Cardwell.

RSI Divergence

J. Welles Wilder, the original developer of RSI oscillator wrote in New Concepts in Technical Trading Systems that divergence between RSI and price movement is an indication that a market turning point is about to take place. While it is a commonly held belief that an RSI divergence indicates that the market is going to change, many RSI experts now believe it more likely signals a temporary retracement/reversal within a continuing trend. Long term divergences are better indicators of trend reversal than short term divergences. Bearish divergence occurs when price makes a new high but the RSI makes a lower high, thus failing to confirm. Bullish divergence occurs when price makes a new low but RSI makes a higher low.

Andrew Cardwell discovered the existence of positive and negative reversals in the RSI oscillator. Reversals are the exact opposite of divergence. A positive reversal occurs when an uptrend price correction results in a higher low compared to the last price correction, while RSI results in a lower low compared to the prior correction. A negative reversal happens when a downtrend rally results in a lower high compared to the last downtrend rally, but RSI makes a higher high compared to the prior rally.

Reversals offer evidence that the main trend is about to resume and often mark excellent entry points into a trend. Typically, positive reversals only happen in uptrends while negative reversals only occur in downtrends, and therefore their existence confirms the trend. A reversal that does not reach it’s price target can sometimes indicate that a trend has ended and that the market will either reverse trend or enter into consolidation.

Using ChartIQ’s RSI Divergence Study

With ChartIQ’s unique RSI Divergence study you can quickly identify Divergences as well as Momentum Discrepancy Reversal Points and benefit from automatic calculation and display of price targets.

To enable the Divergence Study, select RSI from the Studies menu at the top of the screen, and check the Divergence box before tapping the Create button.

Bullish Divergences

Bullish divergence occurs when the market is at a lower point, but RSI is at a higher point. While interruptions of the slope line are tolerated on the price chart, no interruptions of the slope line on the RSI study are permitted to complete a divergence.

In ChartIQ, a bullish divergence is indicated in two ways. First, in the study panel by a green triangle with the hypotenuse extending from the low point of RSI to the high point. Note that the green hypotenuse must be uninterrupted by spikes of the RSI line.

On the price chart, a green line will be extended vertically from the low price point upward, indicating a price target for the retracement. The price target is calculated by taking the price difference between the high and low price points of the price slow and then adding that to the highest point in between.

Bearish Divergences

Bearish divergence is just the opposite, and indicated by a red triangle in the study panel, and a red price target line dropping from below the high price point.

A red line will be extended downward from the high price, indicating a price target for the retracement. The price target is calculated by taking the price difference between the high and low price points of the price slow and then adding that to the highest point in between.

Note the image to the left shows two bearish divergences during a single timeframe.

Note that the slope in the RSI panel may not be interrupted, but it may be interrupted on the price chart – this is difficult to detect with the human eye, which is why ChartIQ’s unique indicator provides trading signals that are very often missed by analysts using manual methods. Automated detection also clearly displays “hidden divergences” which are divergences that occur within the context of a larger overall divergence. As such, you will sometimes see clusters of closely plotted divergences.

Negative reversal (Purple) only happens in a down trend – the price has gone down over time, but RSI has gone up. The implication is that the price has further to fall. How much further (the price target at the end of the purple line) is calculated as above.

Positive reversals are the opposite, occurring only during an bullish trend, indicating that the trend is likely to continue, and signaling a positive price target. Positive reversals in ChartIQ are indicated using a blue line, extending upwards to the price target:

Trend Spotting

Trends are demonstrated by alternating divergences and reversals. Using ChartIQ’s divergence tool you will soon see that uptrends are characterized by alternating blue positive reversal lines and red bearish divergence lines. Downtrends are characterized by purple negative reversal lines and green bullish divergence lines. Observation of historical patterns will convince you that these events offer excellent entry points.

Spotting a trend using RSI alternating divergences and reversals

Reversals and divergences can also supplement momentum oscillators while trading sideways markets. Oftentimes a momentum oscillator such as stochastics may suggest an entry point earlier than is optimal. One of the most difficult aspects of sideways trading is when to trade off of momentum resistance and when to wait for the “M” or “W” shape. A reversal or divergence occurring in conjunction with a momentum oscillator signal strengthens the probability for the entry point.

Using Reversals and RSI Divergences in a Sideways Market

Divergence targets are less likely to be reached than reversal targets due to the nature of trending markets. In sideways markets however the divergence price target is just as valid as the reversal target. In either case, when a sideways market fails to reach the target it is a warning that the consolidation is coming to an end. At ChartIQ we have also observed that divergence targets that are reached and exceeded during long trends are good indicators that the trend has ended.